Euro as Usual

In recent weeks, the value of the euro has often been linked to the way in which European leaders handle their sovereign debt crisis. Many observers interpret a weak euro as a vote of no confidence in the crisis measures. But this interpretation is flawed. The euro has little informational value regarding the success or failure of current EU economic and budgetary policies.

Economists prefer to explain fluctuations in the €/$ exchange rate using changes in fundamental variables, such as economic growth, interest rates and inflation rates, on both sides of the Atlantic. EU policies naturally affect these variables. Yet, whichever scenario one chooses regarding the future outcome of EU budgetary policies, they all imply a weaker euro.

Let’s take the optimistic scenarios first. Successful budget cuts will put pressure on government spending in a period in which consumer and investment spending has not yet fully recovered from the crisis. This will hurt economic growth. A robust recovery from the crisis will then have to be generated by stronger external demand. A weaker euro is instrumental in bringing this about. The same applies to partial budgetary reform in combination with debt restructuring in Greece (which might be the most likely scenario). The doom scenarios are that the ECB will engage in substantial monetary financing of Southern debt or that the euro area will fall apart because of competitiveness problems or internal quarrels. Needless to say, these scenarios will also weaken the euro. As all scenarios predict a weaker euro, the exchange rate cannot shed any light on the plausibility of each scenario.

Shortly after the introduction of the euro in 1999 many analysts were disappointed with the initial weakening of the new currency. In an influential paper published in the same year, Giancarlo Corsetti and Paolo Pesenti showed a strong relationship between the €/$ exchange rate and the expected growth differential between the US and the euro area [1]. The weak euro could be explained by the unfavourable outlook for European growth compared to the US. Expected growth was measured using Consensus Economics forecasts, which summarize the forecasts of about 200 economists.

The graph below replicates this exercise for the recent period. We can distinguish three phases. In 2007 the credit crisis first hit the US. Forecasters lowered the outlook for US growth compared to the euro area. In line with economic theory, the euro strengthened between early 2007 and September 2008. This link was abruptly broken in the fall of 2008, when the post-Lehman panic led to a massive flight to US Treasury bills and bonds. The dollar recovered. Next it quickly became clear that the crisis would not bypass Europe. In April 2009 Consensus forecasters made a sizable downward adjustment of expected growth in the euro area. In contrast, the worst seemed to be over for the US economy. Surprisingly, these revisions initially had little effect on the euro, which even strengthened to $1.50 in November 2009. Not until December 2009 did the euro start its downward path under the influence of the Greek budget problems. The puzzle is why it has taken so long. Based on the expected growth outlook the euro weakening should have started in the spring of 2009.

The €/$ rate is currently better in line with fundamentals than last year. We do not need doom scenarios to explain its recent fall. Regarding the expected outcome of the EU crisis packages, I would advise against monitoring the exchange rate. We will have to wait patiently for governments and parliaments to follow up on their good budgetary intentions.